Are My Social Security Benefits Taxable?

The advent of Social Security in 1935 was a response to the economic uncertainty from the Great Depression. It was promoted as a way to provide a cash flow to retired workers.

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When you work for wages, a total of 7.65% of those wages are paid into your Social Security and Medicare account; your employer matches that amount. But unlike an IRA or other retirement vehicle, these are not pre-tax dollars. You must pay income taxes on the funds that are set aside in your Social Security Trust fund for your retirement years.

With other retirement plans, you defer the income taxes, and contributions to retirement plans are not included in taxable wages on your W2. And if it’s an IRA contribution made separately from your employer’s accounting, it is subtracted from income on the tax return before tax is levied. But this is not the case with Social Security and Medicare withholdings.

If you are self-employed, you fund your Social Security and Medicare account via the self-employment tax which is calculated on Schedule SE from your net profit on Schedule C or against K-1 income from your partnership. In this case you are the employer as well as the employee and are required to match your contribution--effectively paying in at a rate of 15.3%. K-1 income to limited partners and shareholders in a Sub S Corporation are not subject to self-employment tax.

Taxing the Benefits

So after years of paying income taxes on your “contributions” you are ready to retire and collect the benefits—only to find out that they may be taxable! It doesn’t seem fair, does it? Well, here’s how that came about: Beginning in 1983 when a financing crisis was discovered in the Social Security system, The National Commission on Social Security Reform, created by President Reagan in 1981, proposed an amendment to Congress to tax Social Security benefits beginning in 1984. The taxes collected are transferred to the trust funds from which the corresponding benefits were paid.

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The IRS provides Notice 703 Taxable Social Security Benefits Worksheet to determine the taxability of benefits. Basically, you must calculate your modified adjusted gross income (MAGI), and then add up all of your income both taxable and interest on tax-free instruments. Also include 50% of your Social Security benefits and Tier 1 Railroad Retirement Benefits. If the MAGI total exceeds the threshold of $25,000 for an individual or $32,000 for a married couple filing a joint return and zero for a married person filing separately who lived with his spouse the entire year, then you must include a portion of your benefits in taxable income.

Because there are always exceptions to the rules, check page six of IRS Publication 915 for worksheets that must be used for special situations to determine the taxability of your benefits.

Here’s how to figure out how much of your benefits are taxable: In general, if your MAGI exceeds the thresholds listed above, then 50% of your benefits will be included in income for tax purposes. However, if your MAGI is more than $34,000 single, or $44,000 for married filing joint, or you are married filing separately and lived with your spouse at any time during the tax year, then up to 85% of your benefits may be taxable.

The fact that contributions are taxable combined with all the talk of the Social Security system heading for bankruptcy may get you thinking about opting out of the Social Security system altogether. It’s possible to do this but only for religious reasons. Use Form 4029 to opt out. If you are a member of the clergy, use Form 4361.

A church or religious organization that does not wish to pay the matching funds for their employees may opt out by filing Form 8274.